CHAPTER 2

Basic Management Accounting Concepts

This chapter introduces basic terminology that is used throughout the text. Accounting is sometimes called
the language of business. Learning the accounting terminology in Chapter 2 is similar to learning a foreign
language. Understanding the accounting terminology in Chapter 2 is crucial to students understanding
topics covered later.

LEARNING OBJECTIVES
After studying Chapter 2, students should be able to:

1. Explain the cost assignment process.

2. Define tangible and intangible products and explain why there are different product cost definitions.

3. Prepare income statements for manufacturing and service organizations.

4. Explain the differences between functional-based and activity-based management accounting

systems.

KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each topic).

1. Cost assignment: Direct tracing, driver tracing, and allocation (Learning Objective 1)

2. Product and service costs (Learning Objective 2)

3. External financial statements (Learning Objective 3)

4. Types of management accounting systems: A brief overview (Learning Objective 4)

1. COST ASSIGNMENT: DIRECT TRACING, DRIVER TRACING, AND

ALLOCATION
An objective of a management accounting information system is to assign costs to products, services, and
customers. Increasing the accuracy of cost assignment produces higher-quality information for decision
making.

A. Cost Assignment Terminology

A cost is the cash (or cash equivalent) value sacrificed for goods or services that are expected to produce
current or future benefits.

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8 Chapter 2

An opportunity cost is the benefit given up when one alternative is chosen over another. Opportunity
costs are not usually recorded in the accounting system; however, opportunity costs should be considered
when evaluating alternatives for decision making.

Expenses are expired costs. Expenses are costs that are used up when generating revenue.

A cost object is any item such as products, departments, customers, and activities for which costs are
measured and assigned.

An activity is a basic unit of work performed within an organization. Activities are cost objects. Examples
of activities include equipment setup, materials handling, and product inspection.

Traceability is the ability to assign a cost to a cost object in an economically feasible way by means of a
cause-and-effect relationship. The more costs that can be traced to a cost object, the greater the accu -
racy of the cost assignments.

Direct costs can be easily and accurately traced to a cost object.

Indirect costs cannot be easily and accurately traced to a cost object.

B. Methods of Cost Assignment

Methods of cost assignment are summarized below:

Methods of Cost Assignment

Direct Tracing Driver Tracing Allocation

Description: identifying and use of drivers to assign assignment of indirect

assigning costs to a costs to cost objects costs to cost objects
cost object that are based on convenience
specifically or or an assumed linkage
physically associated
with the cost object
relies on physical
observation
Cost assignment most precise depends on the quality least accurate
accuracy: of the cause-and-effect
relationship of the
driver and cost

2. PRODUCT AND SERVICE COSTS

Hansen and Mowen discuss four dimensions that differentiate services from tangible products: intan-
gibility, perishability, inseparability, and heterogeneity.
Basic Management Accounting Concepts 9

Two types of output of organizations are summarized below:

Output of Organizations

Goods Services
(tangible products)

Definition: goods produced by converting raw (1) activities performed for a customer
materials using labor and capital or
(plant, land, and machinery) (2) activity performed by a customer
using the organization’s products or
facilities
Examples: laundry detergent accounting services
television dry cleaning services
bicycles video rental
Organization: Manufacturing organizations produce Service organizations produce intangible
tangible products. products.

Product Costs and External Financial Reporting

For external product costing, costs are classified by the function they serve, as summarized below:
Functional Categories
of Costs

Production Costs Nonproduction Costs

(mfg. costs, product costs) (nonmfg. costs, period costs)

Direct Direct Overhead Selling Administration

Materials Labor Costs Costs

Definition: materials labor traceable all product costs to costs of

traceable to to goods or costs other market, research,
goods or ser- services than direct distribute, and development,
vices produced produced materials and service a and general
direct labor product administration
become part of
product order-getting
and order-
filling costs

(table continued on next page)

10 Chapter 2

Direct Direct Overhead Selling Administration

(continued) Materials Labor Costs Costs

Examples: wood in chef in supervision, advertising, executive

furniture restaurant, utilities, customer salaries,
machine indirect service accounting,
operator on materials, research and
assembly line indirect labor development

Product costs, for external financial reporting, are manufacturing costs (direct materials, direct labor, and
manufacturing overhead) that attach to the product and are first inventoried and then expensed when
the product is sold.

Period costs are nonproduction costs (selling and administrative) and are expensed when incurred.

3. EXTERNAL FINANCIAL STATEMENTS

The functional classification of costs is required for external reporting.

Under absorption costing the two major functional categories of expenses are:
1. cost of goods sold (production costs), and
2. operating expenses (nonproduction costs).

Production costs (direct materials, direct labor, and overhead) are product costs because these costs attach
to the product.

If the product is in inventory, the product cost is reported as inventory on the balance sheet.

If the product has been sold, the product costs are recognized as an expense (cost of goods sold) on the
income statement.

Nonproduction costs (selling and administrative costs) are period costs that are expensed each period.

A. Income Statement: Manufacturing Firm

Income computed using a functional classification frequently is referred to as absorption-costing income

or full-costing income because all manufacturing costs are fully assigned or absorbed by the product.

Cost of goods sold consists of the cost of direct materials, direct labor, and overhead attached to the units
sold during a period.

The cost of goods manufactured is the cost of direct materials, direct labor, and overhead attached to the
units produced during a period.

Work in process consists of all partially completed units in production.

Finished goods are goods that are complete and ready for sale.
Basic Management Accounting Concepts 11

Cost flows for a manufacturer are diagramed below:

Cost Incurrence Expense Category

Direct Materials

Direct Labor Work-in-Process Finished Goods Cost of

Inventory Inventory Goods Sold

Overhead

Selling and Operating

Administrative Expense

As direct materials, direct labor, and manufacturing overhead are used in the production process, the asso-
ciated costs are transferred to the Work-in-Process inventory account.

As the goods in process are completed, the associated costs are transferred to the Finished Goods inven-
tory account.

As the goods are sold, the associated costs are transferred to the Cost of Goods Sold account. Thus, the
product costs of direct materials, direct labor, and manufacturing overhead are not expensed until the goods
are sold.

A manufacturing firm might have three inventory accounts on the balance sheet:
1. Raw Materials
2. Work in Process
3. Finished Goods

B. Income Statement: Service Organization

Cost flows for a service firm are diagramed below:

Cost Incurrence Expense Category

Direct Materials

Direct Labor Cost of

Goods Sold

Overhead

Selling and Operating

Administrative Expense
12 Chapter 2

4. TYPES OF MANAGEMENT ACCOUNTING SYSTEMS: A BRIEF OVERVIEW

Functional-based and activity-based management accounting systems are compared below:
Functional-Based versus Activity-Based
Management Accounting Systems

Functional-Based Activity-Based
Management Management
Accounting System Accounting System

Activity drivers: unit-level drivers unit- and nonunit-level drivers

Product cost allocation tracing
assignment emphasis:

Product costing assign production costs to external reporting and internal

objective: inventories and cost of goods managerial use for planning,
sold for external reporting control, and decision making
Control: focus on managing costs, focus on managing activities, use
emphasis on financial measures both financial and nonfinancial
of performance measures of performance
Performance maximization of individual unit maximization of systemwide
maximization emphasis: performance performance

5. APPLICATIONS
Applications for the chapter include the following:

A. In-class Group Practice Tests. See the Study Guide that accompanies the Hansen and Mowen text
for Key Terms Test, Chapter Quiz, or Practice Test that can be used for in-class, group tests. Each
student takes the quiz or test individually without looking at the answers provided in the study guide.
Then ask the students to break into teams of four or five to grade the test and discuss answers.

B. End-of-Chapter Exercises and Problems